Liberating Supply-Fiscal Policy and Technological Innovation in a Multicountry ModelWP/98/95-EAWP/98/95 Summary This paper looks at the consequences of endogenizing technological innovation for the analysis of fiscal policies. Macroeconomic policy analyses rarely consider the supply side of the economy in detail, concentrating instead on cyclical factors. Yet research and development (R&D) expenditures are important determinants of innovation and technological progress, and economic growth. By incorporating recent empirical work on the relationship between R&D spending and technological progress into a large macroeconomic model, this paper looks at some of the consequences of liberating the supply side of the economy for the analysis of fiscal policy. The results indicate that endogenizing total factor productivity magnifies the long-run effects of fiscal policies on the level of real GDP and stretches out the short- to medium-run effects on economic growth. In particular, the paper finds that incorporating R&D-induced innovation into the analysis more than doubles the long-run welfare losses associated with higher government spending or temporary tax cuts and reduces real growth for a very long time. To put it somewhat differently, endogenizing R&D raises the long-run pain of adventurist fiscal policies without providing any extra gain. Furthermore, these costs spill over onto trading partners, because lower levels of technological innovation in any one country hurt the rest of the world through lower demand for their products and through reduced technological spillovers. Indeed, the welfare costs for the rest of the world also approximately double when R&D is included in the model. Several lessons can be drawn from this exercise. First, supply-side considerations can dramatically increase the costs of inappropriate policy actions, both in the short run and in the long run. Second, these increased costs are borne across the world, not simply in the country implementing the policies. The international nature of these supply-side costs strengthens the case for international cooperation and surveillance. |